Investors continued to push stocks higher in the fourth quarter. Many of the concerns they had going into the year – the economy, political gridlock, Europe, China –faded by the year’s end. A number of bearish market pundits threw in the towel this past fall, and there was a distinct sense that the question in most investors’ minds had changed from “when is the correction going to come?” to “how much more might the market gain?”. Economically sensitive sectors of the economy tended to perform a lot better than defensive sectors, especially since the taper talk in May.
U.S. stocks led the way once again. The broadest gauge of U.S. stocks, the Wilshire 5000, gained 10.1%. Larger stocks did a little better (the S&P 500 rose 10.5%), and small stocks made a nice 8.7% gain as well. Industrials were the best S&P sector with a 13.5% gain and utilities were the worst at only 2.8%. It should be noted that gold dropped -9.4% and real estate slid -1.0%. Anything that functions (at least in part) as a hedge against a weakening economy seems to be out of favor right now.
Stronger employment and industrial production, coupled with greater consumer confidence led investors to expect higher interest rates. This caused the dollar to rise versus other foreign currencies, which was a headwind for dollar-based investors investing in foreign securities. Still, foreign stocks gained 5.7% last quarter. Europe once again did the heavy lifting (7.9%), while emerging markets (especially Latin America, which lost another -2.3%) continued to be a drag on performance.
The decline in bonds resumed as stronger economic growth expectations pushed the ten-year Treasury yield to 3%. Overall, bonds lost -0.1%. High yield corporate bonds were again the best performer (gaining 3.6%) as they are more sensitive to economic growth than interest rates. Municipal bonds and emerging market debt rebounded modestly last quarter from deeply oversold conditions, but were still down on the year.
The changes made this past quarter were done to ensure the stock funds we owned were sufficiently economically sensitive. When markets are uncertain, investors tend to favor stocks that pay a higher dividend and those whose earnings are more predictable. There are a number of very good mutual funds that specialize in these types of stocks that we have owned for a long time. When investor confidence improves, however, stocks whose earnings are more volatile or more likely to surprise on the upside come into favor. In other words, investors go from protecting themselves from what might go wrong to increasing their exposure to what might go right. This necessitated a move away from equity funds like BBH Core Select and Sterling Capital and into funds like American New Economy and Oakmark. In real estate, this meant going from income-oriented funds like Nuveen to more growth-oriented funds like Baron. We prefer to make these moves incrementally, because we want to be careful how we increase risk exposure.
Other than somewhat stronger economic reports, the thaw (temporary, I’m sure) in Congress was the unexpected surprise last quarter. Both of these contributed to increased consumer confidence, which lifted stock returns. Who can say what the surprise will be this quarter? We’ve had a run of positive surprises lately (if you recall a year or so ago, Europe was expected to have descended into chaos by now). I hope this fortunate streak continues. 2013 was the second least volatile year in the last 50 (only 1995 saw greater gains with less fluctuation).
I wrote last quarter about zebras needing to be careful at this point in the market cycle. Of course, this is not how human nature works. The longer we go without seeing lions, the more we want to get out into that tasty tall grass. Ultimately this never ends well. It is our job to determine how close we are to that time and be prepared to make adjustments. At this moment, however, nothing that we are seeing (and John does very in-depth research every month) tells us the end is imminent – although our list of concerns is growing. One thing investors should keep in mind is that the last five mid-term election years have seen fairly sizable sell-offs around mid-year.
Commentary – Come On Stocky!
Imagine that you are at a horse racing track. There is a lot of chatter about the various horses, but the sentiment is quite poor on horse number five. If anyone mentions that horse at all, they refer to it as “washed up” or “dead money”. Because of this, it commands long (12 to 1) odds. Surprisingly it comes in second, edging out one of the two favorites. In the second race it gets a little bit more respect (7 to 1), and finishes a close third. In its third race bettors start to notice it and make it one of the favorites. Unfortunately, it finishes out of the money (although far from last). Lowered expectations in the fourth race push the odds back to 8 to 1, but it recovers to come in third. In its fifth race (4 to 1) it wins by a large margin. Now as the sixth race approaches, this horse is all anyone seems to be talking about. It is running against the same horses and the track appears to be in similar condition so you feel very confident it will win again – and you really want to bet on it. The problem is, the odds on horse number five are now 1 to 1. Even if you are right, you can’t make the same amount of money as people who bet on it in the last race. A $10 bet to win at 4 to 1 gave them $50; at 1 to 1 you would have to bet $25 to win $50.
If you haven’t guessed, horse number five is the U.S. stock market – let’s call him Stocky. The first race was 2009, where expectations were so low such that a second place finish behind Emerging Markets still paid off nicely. In 2010, Stocky ran well once again, but that year belonged to “Goldie”. The next year the track was very muddy, conditions that favored bonds and gold once again. Stocky finishes out of the money. In 2012, investors flocked to gold and real estate because each of these had been in the top three for the last three years running. Stocky runs a good race but is ultimately edged out by both “Brick” (Emerging Markets) and “Efa” (International Developed Markets). Still, diversifying one’s bet in all three classes of stocks would have paid well. Stocky won handily in 2013 as we all know. So much so that some regret having split their bet at all. If history teaches us anything, however, it is that betting on the horse everybody expects to win doesn’t pay that much even if it wins, and more often than not it doesn’t win.
Morningstar (among other research organizations) has done studies showing that investor returns have consistently lagged market returns by several percentage points annually. Figure 1 shows the 20 year annualized return of several asset classes along with the return of the average investor (light blue). As you can see most investors underperform. The reason for this is simple – investors tend to feel more favorably about an asset class (be it U.S. stocks, international developed market stocks, emerging market stocks, gold, real estate, U.S. treasury securities, corporate bonds, international bonds, or money market instruments) after it has had a significant increase, and worse about it after it has performed poorly. As a result they tend to buy high and sell low. Many take performance personally, sometimes rejecting forever an asset class that once disappointed them. Winning makes us feel good, but we can’t afford to give in to that emotion. Nothing (and no-one) wins every time.
Source: JP Morgan 1Q 2014 Guide to the Markets
Everybody wants to bet on the favorite and get paid like they are betting on the long shot. You can’t do that – at best you get one or the other. For example, in almost all races, no horse has a greater than 50% chance of winning. In a typical ten horse race, the best horse might win 30% of the time. Yet bettors usually push the odds of that horse winning to lower than the 2 to 1 – far lower than the horse deserves because bettors are emotionally invested and they want it to win. The discerning bettor would rather find a 9 to 1 horse that has an 11% chance of winning, for example, because the odds combined with the probability offer a greater expected return. Better yet, she might prefer to wager that the horse simply “place” (second or better) or “show” (third or better), to increase the odds of a payout albeit at a lower rate. In other words, focusing on risk-adjusted return – rather than simply return – produces greater rewards over time.
The point that I’m trying to make is that success tends to favor those who invest in assets whose virtues are under-appreciated by the masses rather than those whose virtues are well known. Treasury Bonds, for example, do not look very promising right now. Investors have largely turned their collective backs on that asset class, but that just raises the potential payoff should the economy stumble. U.S. stocks, on the other hand, look less and less attractive because investors have pushed their prices so high. I agree that U.S. stocks are the favorite right now, but track conditions are subject to change without warning. If you invested in stocks every time through history when they were as expensive as they are now, you wouldn’t be happy with your results.
The value I believe we bring to the process of investing is the ability to dispassionately look at each asset class and put together an appropriate combination of investment choices for a given risk tolerance. It will always turn out to be the case that had we put all the money on the eventual winner we would have done better, but nobody has that kind of foresight. Investing, like horse racing, involves a great deal of uncertainty. Betting on the front runner is exciting because we all enjoy the thrill of winning, but it is that very desire that keeps the racetracks and proprietary trading desks of Wall Street firms rolling in the money.
We appreciate your continued trust in our management program,
Mark A. Carlton, CFA
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